Our “growth bonds” and Income Growth Portfolio continue to offer high and growing dividends to investors. These are great alternatives for income investors who have been burned by traditional income investments.
The last decade was difficult for income investors. Yields on bonds and stocks slid all through the 1990s. The average money market fund now yields only 1.51%. The 10-year treasury bond yields 4.8%. The stock indexes have dividend yields of less than 2%.
If you need a decent yield, forget money market funds and even treasury bonds. Their yields are low and are not going to rise dramatically in the next few years. Interest rates will rise some as the economy recovers, but the increase won’t be dramatic.
A few years I developed the concept of the “growth bond,” then I put together the Income Growth Portfolio. These investments not only pay you a relatively high current yield, they also have cash payouts that generally grow over time.
Let’s look at Cohen & Steers Realty Shares. This no-load mutual fund distributed dividends of $1.09 per share in 1994. That rose steadily to a payout of $2.24 in 2000 before dropping to $1.51 in 2001. This doesn’t include capital gains distributions. Cohen & Steers invests in real estate investment trusts. Two features of REITs are that they tend to have higher-than-average dividend yields, and those payouts tend to increase over time. They might not increase every year. But they do increase over time.
Corporations that pay dividends almost always preserve their dividend levels – even during recessions. Dividend reductions are rare and occur only when the corporation is either changing its business or is close to bankruptcy. Barron’s reported that 21 of the 30 stocks in the Dow Jones Industrial Index increased their dividends in 2001. The combined dividend payouts for the Dow stocks increased by 5.22% from 2000 – an income increase that far exceeded the inflation rate. None of the 30 stocks cut or omitted its dividend. The yield percentage is a meager 1.81%. But, as you’ve seen, unlike bonds, the actual cash payout from stocks tends to increase. You can get higher income without touching your principal.
The key is to purchase stocks or funds that have generally high yields now and that are likely to increase their payouts over the years. I’ve put together mutual funds that buy such stocks in our Income Growth Portfolio.
Mainstays of the portfolio, of course, are REITs. Despite last year’s decline in the cash payout, Cohen & Steers yields 5.11%. That beats treasury bonds and, as we’ve seen, is likely to increase most years. In addition, reinvested capital gains and appreciation let you occasionally sell some shares in years when income distributions decline.
Utility stocks usually pay high and growing dividends. That’s why American Gas Index and American Century Utilities are in the portfolio. Falling energy prices hurt payouts from many utilities in 2001 and also caused the stock prices to decline. The Dow Jones Utility Index actually had a 3.48% decline in cash distributions. The stocks should reverse course in 2002, and dividends should increase, as energy prices stabilize and perhaps increase as the economy recovers.
American Century Equity Income is among the best at finding corporate stocks that pay higher-than-average yields. In addition to earning a yield of 2.44% the fund had a total return of 21.91% in 2000 and over 11% in 2001. Its only down year since 1995 was a loss of less than one percent in 1999. Dividend distributions declined the last two years. I’ll be watching closely this year to see if the trend reverses. Another good high dividend fund is Vanguard Equity Income.
I round out the Income Growth Portfolio with the PIMCO Total Return bond fund. This is the best of the bond funds. It currently yields more than the stock funds and treasury bonds at 5.27%. Bonds generally yield more than stocks, so adding bonds increases the initial yield from the portfolio.
Those are the Core Portfolio funds. Together they earn a yield of between 4% and 5%. That is as good as treasury bonds, and you have much greater potential for capital gains and higher income in the future.
In the Income Growth Managed Portfolio, we added funds that pay higher yields and have better potential over the next one to three years. Vanguard GNMA has a yield of over 6% and carries slightly more risk than treasury bonds. Last month we added Columbia High Yield bonds to the portfolio. The yield approaches 8%, and I like the potential for strong capital gains in the next year or two.
Suppose you had invested $100,000 in my recommended Income Growth Core Portfolio funds in 1996. Your income distributions that year would have been $4,567. That climbed steadily to $4,952 is 1997, $5,012 in 1998, $5,269 in 1999, and $6,609 in 2000. In 2001 the distributions declined to $5,300. That still put you well above the initial cash payout. In addition, appreciation of the funds and reinvestment of capital gain distributions would have increased the portfolio’s value to $145,613.
The Income Growth Portfolio won’t earn you the highest yields. If you need more income, you can increase the yield by taking just a bit more risk. Drop some of the equity investments and replace them some other vehicles.
One good income vehicle is preferred stock. This is a cross between stocks and bonds that is issued by corporations. You earn a much higher yield than on regular stocks and on most bonds. The value of the preferred shares doesn’t fluctuate with the stock market as much as it does with long-term interest rates. When market rates rise, preferred stock values usually fall.
There are no open-end mutual funds that concentrate in preferred stocks, and I don’t recommend that most investors select individual preferred stocks. Your only other option is to buy closed-end mutual funds that trade on the exchanges with common stocks. There are several choices here. One I favor is Preferred Income Fund (ticker symbol: PFD). It currently yields 6.47%. But it sells at a 4.47% premium to its net asset value. That’s an indication of how much investors desire high yields these days. You might not want to buy PFD when it is selling at a premium. More information can be found at the fund’s web site www.preferredincome.com.
Instead of preferreds, you can put more corporate and high yield bond funds in your portfolio. We added these to the portfolios last month, because they pay high yields and should do well if my economic forecast is accurate.
Corporate bond funds pay yields of 6% to 7%, and high yield bond funds pay 8% and up. My favorite high yield bond fund is Columbia High Yield, and my top corporate bond funds are Vanguard Intermediate Term Corporate and Dodge & Cox Income.
The more preferred stock or bonds you add to the portfolio, the higher your current yield will be. But you also will reduce the potential for the income to grow and to earn capital gains (or to incur capital losses) from the stocks. You have to decide which potential benefit you want the most.
There’s no reason to settle for low yields on treasury bonds and money market funds and to watch your income decline in the future. You can earn higher yields and have the potential for those yields to increase over time.